Convertible bonds

Convertible bonds are bonds that can be converted into common stock at the option of the bondholder. The conversion provision of a convertible bond grants the bondholder the right to convert the bond into a predetermined number of shares of common stock of the issuer. A convertible bond is, therefore, a bond with an embedded call option to buy the common stock of the issuer.[note 1][1]

The first convertible bonds were sold by US railroad companies in the mid nineteenth century. The contemporary convertible bond market is global, with securities being issued in the US, Canada, Europe, Asia Pacific ex Japan, and Japan. [2]

Institutional issuers and purchasers of convertible bonds

Issuers of convertible bonds often do so in order to reduce the interest coupon payable upon the bond issue, or to delay dilution of stock equity holders. [3] The option of stock conversion is a value that investors pay a premium for, so the bond issuer can demand a higher price for the bond, which results in a lower interest coupon on the bond.

Historically, major large financial institutions such as insurance companies, banks, and hedge funds have been major participants in the convertible bond market. Insurance companies have purchased convertibles to gain stock market exposure from bond portfolios; banks have issued convertible bonds to meet regulatory capital requirements, and hedge funds have specialized in convertible bond arbitrage strategies. However, many arbitrage hedge funds closed due to heavy losses in 2007 and 2008 [4], and in June 2011 bank regulators placed restrictions on the use of some types of convertible bonds used to meet capital requirements by very large, systemically important banks. [5]

Convertible bond fundamentals

Convertible bonds possess a number of complex features. The specific terms of a bond's maturity, coupon, and conversion options can be different for each bond and are detailed in the bond indenture. [note 2], that entitles the investor to convert the bonds into a predetermined number of stock shares. [2]

Valuing a convertible bond can be complex due to the hybrid nature of the instrument, as it contains both fixed income and stock market factors. Professional institutional investors tend to use the mathematics of options (colloquially known as "the Greeks") [note 3] to model the non-linear interplay of these factors.

The basic elements in valuing a convertible bond are graphically illustrated in the figure (Figure 1.) to the right. The graph models bond valuation (the base price); the stock conversion value (conversion price x number of shares), and the premium for the conversion option.

Base price

A convertible bond's maturity and fixed interest rate (along with other bond qualifications) are laid out in the bond's indenture. Assuming the underlying stock price of a convertible bond fails to reach the conversion price, and the bond does not default, an investor will receive, at maturity, the defined bond interest and principal repayment. In the graph, the base price is represented by the horizontal yield to maturity investment value line.

Conversion price

The conversion price is established by the bond's indenture. The issuer will declare the number of stock shares (known as the conversion ratio) to be received upon conversion. For example, if the bond is issued at a $1,000 price and is convertible into 20 shares of common stock, the conversion price for the shares will be $50 per share (price divided by convertible shares).

Conversion premium

The conversion premium is calculated as follows:

Conversion Premium = Bond Price - (Stock Price x Conversion Ratio)

Thus, if a bond, with a conversion ratio of 20, was issued at a $1,000 price and the common stock is selling for $42, the conversion premium would be determined as:

$160 = $1,000 - $840 = $1,000 - ($42 x 20)

If the issue is sold at par, then the conversion premium would be 19 percent ([$1,000 - 840]/840).

When the value of a convertible bond's underlying stock is far below the price of the bond, the convertible bond will usually behave more like a conventional bond. Yield to maturity and conversion premiums will generally be high. As the value of the underlying stock moves toward parity with the bond price, the convertible bond will become more sensitive to movements in the stock price, and generally provide lower yields to maturity and lower conversion premiums.[6] Over longer holding periods, convertible bonds have typically realized higher correlations with stock market returns than with bond market returns. [note 5]

Risks

Convertible bonds are subject to the following risks.

Credit risk: Convertible bonds, like all corporate bonds, are subject to credit risk, the risk that an issuer may default on the debt,[note 6] or that the bond will be subject to downgraded status due to deteriorating corporate finances and/or deteriorating economic conditions. Many convertible bonds are not investment grade bonds. [note 7] On a fundamental level, convertible bonds are subordinated debt, meaning that, in default an issuer's conventional bonds must be paid before convertible bonds can be redeemed.

Interest rate risk: When the value of a convertible bond's underlying stock is far below the price of the bond, the bond will be more subject to price fluctuation caused by changing market interest rates. These changes will be tied to the bond's duration. Movements in the bond's value towards the price of conversion is marked by an increasing positive convexity in the duration. [2]

Equity risk: As the convertible bond moves towards or surpasses conversion parity, the bond becomes more influenced by the movement of the underlying stock price, usually with an increase in volatility. While the interest earned by convertible bonds helps cushion downside risk, convertible bonds can experience considerable declines in market value, as shown in the market performance of US convertible bonds during bear markets in stocks: [6]

Bear market performance

Peak to trough of S&P 500

Convertibles

Equity

Sept. 1, 2000 - Oct. 9, 2002

-35.1%

-47.4%

Oct. 9, 2007 - March 9, 2009

-42.9%

-55.3%

Call risk: Convertible bonds are frequently issued with call provisions which give the issuing company the right to redeem the bonds prior to the scheduled maturity date. Called bonds can experience shifting duration, convexity, and yield to maturity depending on interest rate movements. In addition to call provisions, some convertible bonds stipulate a mandatory conversion. [7]

Sector concentration risk: Convertible bonds tend to be retired at higher rates than conventional bonds of the same maturity due to maturation, being called, or being converted to stock. The resulting higher turnover can result in rapid changes in the convertible bond market. If newly issued convertibles are offered in just a few economic sectors, the concentration can result in increased volatility. [8]

Convertible bond indexes

Suites of convertible bond indexes are available from the following index providers:

EXANE Convertible Securities: ECI refers to a range of European Convertible Indexes. [10]

Jefferies Active Convertible Index : The core JACI indexes are a normalized price-weighted composition and the flagship index is the JACI Global - a blend of four major regions in pre-specified blending ratios. [11]

Merrill Lynch Convertible Bond Indexes: There are three groups of indexes; the first two, the G300 Global Convertible Master Index and the Global Investment Grade Convertible Master Index, concentrate the larger more liquid issues, and tend to be the most appropriate for benchmarking. [12]

UBS Convertible Indexes: UBS Convertible Indexes measure the size and performance of the convertibles asset class, and are the most widely used convertible bond benchmark internationally. [13]

Convertible bond index returns

The returns of US convertible bonds, as measured by the Bank of America Merrill Lynch All Convertibles ex Mandatory Index is included in the table below.

Larry Swedroe and Jared Kizer argue against including convertible bonds in portfolios in The Only Guide to Alternative Investments You'll Ever Need: The Good, the Flawed, the Bad, and the Ugly. Among the reasons cited [15]:

A convertible bond's performance shifts from being bond-like to being stock-like. This results in a shifting asset allocation which makes it impossible to accurately determine a fixed stock/bond asset allocation.

The hybrid bond/stock character of convertible bonds presents an asset location dilemma, since equity investments are often best held in taxable accounts, while higher yielding income investments are best held in tax preferred accounts.

If the convertible bond is callable, it is usually called at a time more advantageous to the issuer than to the investor.

Exchange traded funds

Mutual funds

The mutual fund universe of contains a large number of convertible bond funds, most of which are broker-distributed load funds. Morningstar tracks performance of these funds, categorizing them as "convertibles". [17] The average expense ratio for convertible bond funds, as reported by Morningstar, is 1.13% per annum.

Convertible bond funds are also available as closed-end funds. These funds are traded on stock exchanges, often trade at discount or premium to net asset value, often employ leverage, and often utilize managed distribution policies. Most have higher than average expense ratios.

Active funds add to the risks inherent in investing in bond funds by introducing manager risk; the chance that poor security selection or focus on securities in a particular sector or category will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

In addition, active convertible bond funds usually contain additional securities other than convertible bonds such as convertible preferred stock. They may also hold a shifting mix of US and international convertible securities.

Notes

↑An exchangeable security grants the bondholder the right to exchange the bond for the common stock of a firm other than the issuer of the bond. (Ref: Finance: Capital Markets, Financial Management, and Investment Management)

↑ An indenture is "a contract between an issuer of bonds and the bondholder stating the time period before repayment, amount of interest paid, if the bond is convertible (and if so, at what price or what ratio), if the bond is callable and the amount of money that is to be repaid." Indenture, investopedia definition.

↑ See Greeks (finance) for a listing of the mathematical functions used in valuing options.

↑ The graph is based on the following inputs. Assume that a new issue convertible has come to market. It has a 5 percent coupon and 10 years to maturity. The issuing company has other 10 year debt that carries an 8 percent yield, and the company's stock is currently trading at $42.The bond indenture specifies a conversion price of $50. Since we know that the conversion price is the effective price for conversion into stock with the bond at par, we divide the par value of the bond ($1,000) by $50, resulting in a conversion ratio of 20 shares. To calculate the current conversion value, we know that the stock price is currently $42. Multiplying $42 by 20 shares, we get a current conversion value of $840. If the issue is sold at par, then the conversion premium would be 19 percent ([$1,000 - 840]/840). The investment value of the convertible at issuance would be the security with the 5 percent coupon discounted at a yield to maturity of 8 percent. The result, according to standard bond calculations, is 79.87, or a dollar value of $798.70. The investment premium would be 25.20 percent ([$1,000 - 798]/798)- from Calamos Investments - Convertible Bond Example

Historical loss rates: The one-year average loss rate for convertible bonds is 1.05%, compared with 0.63% for all non-convertible bonds. "The fact that most convertible bonds are contractually or effectively subordinated seems to underlie this result."

Recovery rates: recovering on average $29 per $100 par for defaulted convertible bonds compared with $43 per $100 par for straight bonds.